What are the property tax implications of dissolving an LLC? How will taxes be affected if this reader dissolves the LLC the rental property is held in?
What Are the Property Tax Implications of Dissolving an LLC
Q: I own a rental property that I put into a limited liability company (LLC). Now, I’m planning to make this property my primary residence. Should I dissolve the LLC? Would there be any taxes on this change? Thanks for your advice.
A: We’ll give you a partial answer here but to get the real story, you’ll really need to sit down with a tax expert to go over your particular situation.
From one perspective, this rental property is owned by a company you own: a limited liability company (LLC). Over the years, this LLC received income from rent and paid your expenses on the property. At the end of each year, the LLC had a profit or loss and the LLC’s business is owning the rental property.
It’s generally hard for a homeowner to claim a property owned in an LLC as a primary residence for real estate tax purposes, if you live in a state where there are real estate taxes. With a few exceptions, it’s also hard to claim the home is your primary residence on your federal income taxes while the property is owned in an LLC.
Transferring the property out of the LLC could pose a number of problems. From a local law perspective, that transfer in some states could trigger the payment of real estate transfer taxes, and could trigger a reassessment or reevaluation of the property causing the real estate taxes to go up substantially.
Federal Income Tax Consequences of Transferring a Property Out of an LLC
Then there are the federal income tax consequences. Many people that own property in an LLC report any gains or losses from the ownership of a rental property on their personal tax return. Professionals in the industry describe this as the LLC being a “disregarded entity.” If you file a separate tax return for your LLC and it’s not a disregarded entity, the transfer of ownership from the LLC to you may be considered a sale of the LLC and you’d have capital gains and other taxes to pay from the transfer.
The best case scenario is that you own the property in the LLC, for federal income tax purposes, the LLC is a disregarded entity; the transfer of the property from the LLC to your name would not trigger any real estate transfer taxes or cause the local taxing authorities to raise your taxes. If this is all true, then we get to the fun part. You now own the property in your own name. You would no longer be able to depreciate the property, you might be limited in the deductibility of real estate taxes but you’d own it in your name.
Home Sale Exclusion Benefit for Primary or Secondary Residences
You might not notice much difference owning it in your own name, but come time to sell the property, the differences will be huge. If this property had always been your primary residence or even a second residence but not a rental property, and you lived in it for two out of the last five years, you’d be entitled to keep your profits from the sale of the home without paying any federal income taxes on those profits. If you’re single, you can exclude up to $250,000 of profits from federal income taxes and if you are married, you and your spouse could exclude up to $500,000 from federal income taxes.
Keep in mind, there are other requirements. So, if you had a profit of $200,000 on the sale, you’d get to keep the money and pay no federal income taxes on the sale.
But because you once owned the property in an LLC, as a rental property, you won’t get the full benefit of the home sale exclusion. Uncle Sam will want you to pay taxes on the sale to recapture the depreciation you took when the property was a rental.
Property Tax Implications of Dissolving an LLC
Depending on a variety of factors, the IRS could say that you owned the home for eight out of 10 years as a rental property, the IRS may claim that you owe tax on 80 percent of the profits and could use the home sale exclusion for the other 20 percent. So, the longer you own the property as a primary residence, the more benefit you’d get from the home sale exclusion.
So this leads us back to where we started. You need to talk to a good tax professional (because we’ve really simplified our answer. There are other complications that relate to the amount of depreciation you took on the property over the years, etc.) who can walk through your options and go over what your intentions are and the reasons you want to make the home your primary residence and those reasons could influence what you want to do with the home.
If you simply thought you could keep it for two years from the time you make the property your primary residence to get the full benefit and now you know that that won’t work, you might decide to keep it as a rental or sell it and buy something else with the money and use a 1031 tax deferred exchange to sell the old rental property to buy a new one.